Entering the Secret Garden of Private Equity

Perhaps so, judging by the decision of a venerable private equity firm to allow investors in one of its funds to hire an independent adviser to monitor the fund’s practices. Beyond reviewing the books and financial records at the fund, the outside adviser would also be permitted to scrutinize the fund’s governance practices for conflicts of interest, the firm said.

This shift in practice, which has not been previously reported, was disclosed to investors in June by Freeman Spogli & Company, a $4 billion private equity firm created more than 30 years ago, in a letter laced with legal jargon that obscured the import of the decision.

The new policy applied to the firm’s newest fund: FS Equity Partners VII, which opened for investment this year and has closed with $1.3 billion in committed funds. Investors in that fund include pension funds and public investments, such as the Kansas Public Employees Retirement System, the New Mexico State Investment Council and the New York State Common Retirement Fund.

Freeman Spogli, according to its website, typically invests in medium-size consumer and distribution businesses. Its current investments include Petco, the pet supplies retailer; Boot Barn, a chain of Western wear stores; and Totes Isotoner, the maker of umbrellas, boots and accessories. Ronald P. Spogli, co-founder of the firm, was ambassador to Italy under President George W. Bush.

Allowing the appointment of a monitor is no small matter. Giving an outsider routine access to internal fund operations is practically unknown in the $3.5 trillion private equity industry, where powerful firms operate in near secrecy and hold so much sway that many investors say they feel fortunate to be allowed to put money into the funds. The independent adviser will report to the fund’s investors.

Karl Olson is a partner at Ram, Olson, Cereghino & Kopczynski who has sued the California Public Employees’ Retirement System, known as Calpers, to force it to disclose fees paid to hedge fund, venture capital and private equity managers. He said he had never seen a provision allowing an independent monitor at a private equity fund.

“It does seem like a step in the right direction because too often the limited partners are unduly passive,” he said, referring to investors. “They should feel they are in the driver’s seat and that they have an obligation to drive a hard bargain with the funds."Phone calls seeking comment at both the New York and Los Angeles offices of Freeman Spogli were not returned.

Freeman Spogli may not have acted out of the goodness of its heart. Documents obtained by The New York Times show that the independent adviser appointment was disclosed after officials at the Securities and Exchange Commission raised questions about several of the firm’s practices. Those questions arose from an examination in April 2013 related to two older Freeman Spogli funds and were posed in a private letter that the S.E.C. sent to the firm in May 2013.

According to the letter, S.E.C. officials said that Freeman Spogli appeared to be violating fee-sharing arrangements with its investors in two funds, despite promises to the contrary. And Freeman Spogli, the S.E.C.'s letter said, appeared to be reaping fees from investment-banking-type transactions without fulfilling the regulatory requirement of being registered as a broker-dealer.

Private equity firms use borrowed money to acquire companies that they hope to resell at a profit. It is no secret that fees charged to investors in private equity funds are high. Many investors view those fees as the cost of entry into a hot investment arena.

This year, the problem of hidden and possibly abusive fees at these funds has been brought to light in several articles in The Times. Many investors, for example, did not know that private equity firms could charge fees for monitoring an investment even after it had been sold. Neither did most investors realize that they were responsible for the payment of legal settlements if private equity executives were accused of wrongdoing. One reason investors are often in the dark in these matters is that the terms of the agreements they strike with the private equity firms are kept confidential, even from beneficiaries.

The S.E.C. declined to comment on the Freeman Spogli situation specifically, but Drew Bowden, director of the S.E.C.'s office of compliance inspections and examinations, said the increased scrutiny being brought to bear in the private equity industry is resulting in industry changes. “You see investors asking questions they didn’t formally ask before, insisting on certain terms and refusing certain terms,” Mr. Bowden said. “Advisers are also modifying their behavior and realizing the tolerance for certain terms is not there.”

Private equity firms oversee assets belonging to endowments, pension funds and wealthy individual investors. The firms typically charge these investors 2 percent of assets annually as well as 20 percent of any gains their portfolio companies generate. The investments are usually locked up for at least five years.

Historically, private equity funds have been stellar performers. But in recent years, their performance has dimmed; over the last five years, on average, they have lagged the returns of the broad stock averages.

Amid this decline, some investors have raised concerns about hidden fees levied by private equity funds. They include fees paid by the companies held in the private equity firm’s portfolio. The companies end up paying fees to the private equity firm for things like issuing debt or the oversight of portfolio companies, known as monitoring services.

Responding to investor demands, private equity firms now routinely reduce management fees charged to investors by the amount of these expenses, or some portion of them. These arrangements vary from firm to firm and range from offsets of 50 percent of fees to 100 percent.

Investors in funds with these fee arrangements usually rely on the private equity firms to ensure that offsets are properly applied. Considering what transpired at Freeman Spogli, that trust may not always be justified.

The business of private equity has for decades been almost unregulated. But the Dodd-Frank legislation of 2010 required private equity firms with more than $150 million in assets to register as investment advisers with the S.E.C. That registration process began in 2012, and the commission began visiting firms to review their records and practices.

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Ronald P. Spogli, above in 2005, when he was the United States ambassador to Italy. He is co-founder of Freeman Spogli, a $4 billion private equity firm.CreditAlessandra Tarantino/Associated Press

Since the S.E.C. began conducting its first examinations of private equity firms, some of its officials, including Mr. Bowden, have spoken publicly about industry problems. But specifics about improper practices in the area have been few, and enforcement actions rare.

The Freeman Spogli documents shed light on some of the S.E.C.'s concerns about private equity. Not surprisingly, they revolve around fees that these firms charge.

The S.E.C.'s review of the firm’s operations highlighted two critical problems. One deficiency related to the firm’s fee-sharing practices. Like many private equity firms, Freeman Spogli had promised to reduce the management fees paid by investors; those reductions are supposed to offset some or all of the transaction fees and other charges levied on its portfolio companies.

But the S.E.C. found that certain affiliates of Freeman Spogli did not fully offset the transaction and consulting fees from companies held in their portfolios, as well as bonuses and reimbursed expenses, as required by two of its funds’ limited partnership agreements. The two funds were Freeman Spogli Equity Partners V and VI. The firm’s failure to reduce the management fee in both funds was inconsistent with its fiduciary duty, the S.E.C.'s letter said. It asked Freeman Spogli to reimburse the two funds and to “provide evidence of any completed reimbursement.”

The S.E.C. findings suggest that investors need to be more vigilant about ensuring that the fee-sharing arrangements they have been promised by private equity firms are actually followed.

The other practice cited by the S.E.C. involved Freeman Spogli’s apparent acceptance of fees for providing investment banking-type services even though it was not registered as a broker-dealer. The same two funds were cited in the letter.

“It appears as though Registrant,” the letter said, referring to Freeman Spogli, “and its Affiliated Executives may be and have been acting as unregistered broker-dealers based on the receipt of such compensation.” The letter added, “Please explain any legal analysis conducted by, or on behalf of, Registrant in determining whether broker-dealer registration is appropriate, including any legal basis or authority on which Registrant has relied.”

The commission has questioned other private equity firms about their brokerage activities. One is the Clearlake Capital Group of Santa Monica, Calif. After an S.E.C. examination in 2013, Clearlake also received a deficiency letter about unregistered broker-dealer activities.

In July, Clearlake, responding to questions by one of its pension investors, said it had replied to the deficiency letter, and that the S.E.C. had requested additional information on the matter, according to documents made available to The Times. Email messages to Clearlake asking about the status of the broker-dealer matter were not returned.

Adam Gale, a lawyer at the Mintz Levin firm and co-chairman of its investment funds group, said broker-dealer registration remains an important issue for S.E.C. examiners in their visits to private equity funds.

Securities laws state that “any person engaged in the business of affecting transactions in securities for the account of others” should register as a broker and submit to heightened oversight intended to ensure that its customers are treated fairly.

S.E.C. guidelines echo that: Firms may have to register as broker-dealers if they participate in “important parts of a securities transaction, including solicitation, negotiation or execution of the transaction” and if compensation or participation in the deal depends on the outcome or size of the transaction.

But many private equity firms are not registered as brokers, even though they conduct such transactions. “The registration obligation might kick in if the fund manager or an affiliate is charging success-based fees when the fund is buying or selling a portfolio company,” Mr. Gale said.

Most large private equity firms, including Apollo Global Management, the Blackstone Group and KKR, are already registered as broker-dealers. And the registration requirement, Mr. Gale said, may be eliminated if a private equity firm rebates any broker-type charges against its management fee.

Smaller firms typically are not registered as brokers, Mr. Gale said. And one result of S.E.C. scrutiny in this area, he said, is that some smaller firms are deciding against charging any investment banking-type fees. “It’s a regulatory headache, and it takes money, time and effort to register as a broker-dealer and to keep up with the ongoing requirements,” he said.

With private equity firms under the regulatory microscope, the balance of power may be shifting — at least a bit — away from fund executives and toward investors. The investors in the Freeman Spogli fund, for example, are being given a much more active role in oversight than is typical at private equity funds.

Eileen Appelbaum is senior economist at the Center for Economic and Policy Research in Washington and co-author with Rosemary Batt of “Private Equity at Work: When Wall Street Manages Main Street.” Told about the change at the Freeman Spogli fund allowing an independent adviser to monitor its operations, Ms. Appelbaum called it a positive development, especially given the complexity in fee-sharing arrangements.

“It can be very confusing to the limited partners to understand which are the fees that should be shared with them,” she said in an interview.

If the practice of hiring an independent monitor took hold at other funds, she added, questionable actions in the industry might change.